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Market Risk

Risk which is common to an entire class of assets or liabilities. The value of investments may decline over a given time period simply because of economic changes or other events that impact large portions of the market. Asset allocation and diversification can protect against market risk because different portions of the market tend to underperform at different times. also called systematic risk.

One of six risks defined by the Federal Reserve.

The risk of an increase or decrease in the market value/price of a financial instrument.

Market values for debt instruments are affected by actual and anticipated changes in prevailing interest rates.

Market values for all financial instruments, except direct obligations of the U. S. Treasury, are affected by either actual or perceived changes in credit quality.’ market risk’ includes reinvestment risk – that is, the risk that all or part of the principal may be received when interest rates are lower than when the security was originally purchased.

In that case, the principal must be reinvested at a lower rate than that originally received. Sometimes called market value risk.

Also see interest rate risk and price risk.

Background

From January 1st, 1998, internationally-active banks in G-10 countries had to maintain regulatory capital to cover market risk.

This is the risk to an institution’s financial condition resulting from adverse movements in the level or volatility of market prices of interest rate instruments, equities, commodities and currencies. Market risk is usually measured as the potential gain/loss in a position/portfolio that is associated with a price movement of a given probability over a specified time horizon. This is typically known as value-at-risk (VAR). An institution with a 10-day VAR of $100 million at 99% confidence will suffer a loss in excess of $100 million in one fortnightly period out of 20, and then only if it is unable to take any action to mitigate its loss.

Many banks calculate one-day VAR numbers which are then compared with actual daily profits and losses. It is much easier for them to scale up these numbers by the square root of 10 to meet the 10-day holding period laid down by the Basle Committee than to start afresh. But scaling up daily numbers to reflect a longer unwind period is fine for linear products such as forwards and swaps but not good enough for options and products with embedded options. Extrapolating daily VAR numbers does not capture the gamma or curvature risk of such products. The best way of capturing this curvature is to use longer holding periods which explains why the Basle Committee opted for a 10-day holding period. But the Committee wanted to limit industry burden in complying with its pronouncements and thus decided that banks could scale up their one-day numbers for a limited period. These banks are however asked to assess the option risk in their portfolios by applying Monte Carlo simulation and/or stress testing.